ETF INVESTOR: In the early years, ETFs offered low-cost, quality access to benchmark indices. Most of them are still good, but there is more rotten fruit too, some of it rotten to the core.

Growing up in Niagara, autumn was apple season. On a brilliant October Saturday, we’d fill bushels with glossy Red Delicious orbs. For the first couple of bushels, we’d carefully inspect each and every fruit. By about lunch time, with stomachs bloated and brains addled by fructose, we weren’t so discerning and some rotten ones would slip by.

The same holds true for ETFs. In the early years, they offered low-cost, quality access to benchmark indices. The orchard grew quickly and now there are bushel loads of products available. Much of them are still good, but there is more rotten fruit too, some of it rotten to the core. Before I stretch the analogy too far, let’s take a look at one type of these, the leveraged long/short spread ETF.

Say you have a weird post-turkey dream next week in which the S&P 500 crashes and crude oil rallies. You wake up and what do you do? You buy the FactorShares 2x: Oil Bull/S&P 500 Bear ETF (FOL/NYSE). Besides the fact your dream is nonsensical — why would oil rally if equities are falling? — you will regret your action. The turkey will exact its revenge, causing you to seriously consider going vegetarian.

How one small ETF such as FOL can embody so much that is rotten in the ETF world is incredible. First, it is leveraged. For every $1 invested, FOL buys $2 worth of exposure to the markets.

Leverage is like borrowing to invest and it magnifies returns, both positive and negative. If you have a mortgage, you have leveraged exposure to the housing market.

However, leverage within an ETF does not always produce the advertised return. The fine print on every leveraged ETF explains that the 2x return promise is good for one day only. Hold it any longer and the promise is void.

The mechanics of managing a leveraged ETF mean the manager is always playing catch-up with the market, either adding exposure after the price has gone up or cutting exposure after it has fallen. When volatility is low, this will be a drag on leveraged returns. But when volatility is high, the leveraged returns become completely unpredictable.

Consider the Horizons Beta Nymex Crude Bull Plus ETF (HOU/TSX) and its bearish inverse twin, HOD/TSX, compared to the iPath Goldman Sachs Crude Oil ETF (OIL/NYSE), a similar but unleveraged ETF. In 2011, a fairly volatile year for crude, OIL was down about 2%. In theory, you’d expect HOU to be at -4% and HOD at +4%. In fact, HOU was down nearly 19% and, even stranger, HOD was down nearly 27%.

In the year to date, with volatility somewhat reduced, the twins have performed more in line with expectations. OIL is down 15%, bullish HOU is down about 32% and bearish HOD is up 15%, though that is still 15 percentage points short of where you would expect it.

Going back to FOL, that ETF combines leverage and inverse features making it doubly rotten. But it gets worse.

Most commodity ETFs use futures contracts to replicate the actual commodity. But due to storage and financing costs, oil for delivery in one or two months is more expensive than oil for delivery today. That is called contango and it erodes returns.

If the price of oil was to remain unchanged at its current US$92 level for the next six months, the OIL ETF would still lose money because of contango — the manager buys futures contracts and watches them lose value as they age. The leveraged-to-oil HOU and FOL would lose even more. In theory, the inverse bearish HOD should benefit from contango, but we’ve seen how well that theory holds.

ETFs that offer leveraged or inverse exposure or are subject to contango are all rotten in their own way. But combine all three of those features into one package like FOL does and it is a disaster for investors, but also for the managers of quality ETFs who are deemed guilty by association. FOL has lost 61% since its debut in February 2011.

Perhaps the worst thing about FOL is its smart-aleck attitude. The buyer of FOL is saying: “I am so sure that oil is going up I am ready to double my bet with borrowed money. Furthermore, I’m so bearish on equities that I’ll double my bet against those. And I am so smart that I will get the timing just right.”

That kind of arrogance has humbled many hedge funds whose speciality is attitude. At least they only target the truly wealthy. But wrap these strategies into ETFs like FOL, OIL and the HO twins, target the ETFs at individual investors, and they become those decayed, rotten apples that are good only for spreading on the field come November .